Friday, December 5, 2008

Fekete - Red Alert: Gold Backwardation!!!

December 2, 2008, was a landmark in the saga of the collapsing international monetary system, yet it did not deserve to be reported in the press: gold went to backwardation for the first time ever in history. The facts are as follows: on December 2nd, at the Comex in New York, December gold futures (last delivery: December 31) were quoted at 1.98% discount to spot, while February gold futures (last delivery: February 27, 2009) were quoted at 0.14% discount to spot. (All percentages annualized.) The condition got worse on December 3rd, when the corresponding figures were 2% and 0.29%. This means that the gold basis has turned negative, and the condition of backwardation persisted for at least 48 hours. I am writing this in the wee hours of December 4th, when trading of gold futures has not yet started in New York.

According to the December 3rd Comex delivery report, there are 11,759 notices to take delivery. This represents 1.1759 million ounces of gold, while the Comex-approved warehouses hold 2.9 million ounces. Thus 40% of the total amount will have to be delivered by December 31st. Since not all the gold in the warehouses is available for delivery, Comex supply of gold falls far short of the demand at present rates. Futures markets in gold are breaking down. Paper gold is progressively being discredited.

Already there was a slight backwardation in gold at the expiry of a previous active contract month, but it never spilled over to the next active contract month, as it does now: backwardation in the December contract is spilling over to the February contract which at last reading was 0.36%. Silver is also in backwardation, with the discount on silver futures being about twice that on gold futures.

As those who attended my seminar on the gold basis in Canberra last month know, the gold basis is a pristine, incorruptible measure of trust, or the lack of it in case it turns negative, in paper money. Of course, it is too early to say whether gold has gone to permanent backwardation, or whether the condition will rectify itself (it probably will). Be that as it may, it does not matter. The fact that it has happened is the coup de grâce for the regime of irredeemable currency. It will bleed to death, maybe rather slowly, even if no other hits, blows, or shocks are dealt to the system. Very few people realize what is going on and, of course, official sources and the news media won’t be helpful to them to explain the significance of all this. I am trying to be helpful to the discriminating reader.

Gold going to permanent backwardation means that gold is no longer for sale at any price, whether it is quoted in dollars, yens, euros, or Swiss francs. The situation is exactly the same as it has been for years: gold is not for sale at any price quoted in Zimbabwe currency, however high the quote is. To put it differently, all offers to sell gold are being withdrawn, whether it concerns newly mined gold, scrap gold, bullion gold or coined gold. I dubbed this event that has cast its long shadow forward for many a year, the last contango in Washington ― contango being the name for the condition opposite to backwardation (namely, that of a positive basis), and Washington being the city where the Paper-mill of the Potomac, the Federal Reserve Board, is located. This is a tongue-in-cheek way of saying that the jig in Washington is up. The music has stopped on the players of ‘musical chairs’. Those who have no gold in hand are out of luck. They won’t get it now through the regular channels. If they want it, they will have to go to the black market.

I founded Gold Standard University Live (GSUL) two years ago and dedicated it to research of monetary issues that are pointedly ignored by universities, government think-tanks, and the financial press, centered around the question of long-term viability of the regime of irredeemable currency. Historical experiments with that type of currency were many but all of them, without exception, have ended in ignominious failure accompanied with great economic pain, unless the experiment was called off in good time and the authorities returned to monetary rectitude, that is, to a metallic monetary standard. It is also worth pointing out that the present experiment is unique in that all countries of the world indulge in it. Not one country is on a metallic monetary standard, under which the Treasury and the Central Bank are subject to the same contract law as ordinary citizens. They cannot issue irredeemable promises to pay and keep them in monetary circulation through a conspiracy known as check-kiting. Not one country will be spared from the fire and brimstone that once rained on the cities of Sodom and Gomorrah as a punishment of God for immoral behavior.

In all previous episodes there were some countries around that did not listen to the siren song and stayed on the gold standard. They could give a helping hand to the deviant ones, thus limiting economic pain. Today there are no such countries. If you want to be saved, you must be prepared to save yourself.

You cannot understand the process whereby a fiat money system self-destructs without understanding the gold and silver basis. The Quantity Theory of Money does not provide an explanation, because deflation may well precede hyperinflation, as it appears to be the case right now.

For these reasons I placed the study of the gold and silver basis on the top of the list of research topics for GSUL. These can serve as an early warning system that will signal the beginning of the end. The end is approaching with the inevitability of the climax in a Greek tragedy, as the heroes and heroines are drawn to their own destruction. The present reactionary experiment with paper money is entering its death-throes. GSUL has had five sessions and could have established itself as an important, and even the only, source of information about this cataclysmic event: the confrontation of the Titanic (representing the international monetary system) with the iceberg (representing gold and its vanishing basis) as the latter is emerging from the fog too late to avoid collision.

Unfortunately, this was not meant to be: GSUL has to terminate its operations due to a decision made by Mr. Eric Sprott, of Sprott Asset Management, to terminate sponsoring GSUL, saying that “results do not justify the expense.”

I sincerely regret that our activities did not live up to the expectations of Mr. Sprott, but I am very proud of the fact that our research is still the only source of information on the vanishing gold basis and its corollary, the seizing up of the paper money system that threatens the world, as it does, with a Great Depression eclipsing that of the 1930’s.

Let me summarize the salient points of discussion during the last two sessions of GSUL for the benefit of those who wanted to attend but couldn’t. The gold basis is the difference between the futures and the cash price of gold. More precisely it is the price of the nearby active futures contract in the gold futures market minus the cash price of physical gold in the spot market. Historically it has been positive ever since gold futures trading started at the Winnipeg Commodity Exchange in 1972 (except for some rare hiccups at the triple-witching hour. Such deviations have been called ‘logistical’ in nature, having to do with the simultaneous expiry of gold futures and the put and call option contracts on them. In all these instances the anomaly of a negative basis resolved itself in a matter of a few hours.)

In the commodity futures markets the terminus technicus for a positive basis is contango; that for a negative one, backwardation. Contango implies the existence of a healthy supply of the commodity in the warehouses available for immediate delivery, while backwardation implies shortages and conjures up the scraping of the bottom of the barrel. The basis is limited on the upside by the carrying charges; but there is no limit on the downside as it can fall to any negative value (meaning that the cash price may exceed the futures price by any amount, however large).

Contango whereby the futures price of gold is quoted at a premium to the spot price is the normal condition for the gold market, and for a very good reason, too. The supply of monetary gold in the world is very large relatively speaking. Babbling about the ‘scarcity of gold’ reflects the opinion of uninformed or badly informed people. In terms of the ratio of stocks to flows the supply of gold is far and away greater than that of any commodity. Silver is second only to gold. It is this fact that makes the two of them the only monetary metals. The impact on the gold price of a discovery of an extremely rich gold field, or the coming on stream of an extremely rich gold mine, is minimal ― in view of the large existing stocks. Paradoxically, what makes gold valuable is not its scarcity but its relative abundance, which evokes that superb confidence in the steadiness of the value of gold that will not be decreased by a banner production year, nor can it be increased by withdrawing gold coins from circulation. For this reason there is no better fly-wheel regulator for the value of currency than gold. The same goes, albeit to a lesser degree, for silver.

Here is the fundamental difference between the monetary metal, gold, and other commodities. Backwardation will pull in stocks from the moon as it were, if need be. The cure for the backwardation of any commodity is more backwardation. For gold, there is no cure. Backwardation in gold is always and everywhere a monetary phenomenon: it is a reminder of the incurable pathology of paper money. It dramatizes the decay of the regime of irredeemable currency. It can only get worse. As confidence in the value of fiat money is a fragile thing, it will not get better. It depicts the paper dollar as Humpty Dumpty who sat on a wall and had a great fall and, now, “all the king’s horses and all the king’s men could not put Humpty Dumpty together again.” To paraphrase a proverb, give paper currency a bad name, you might as well scrap it.

Once entrenched, backwardation in gold means that the cancer of the dollar has reached its terminal stages. The progressively evaporating trust in the value of the irredeemable dollar can no longer be stopped.

Negative basis (backwardation) means that people controlling the supply of monetary gold cannot be persuaded to part with it, regardless of the bait. These people are no speculators. They are neither Scrooges nor Shylocks. They are highly capable businessmen with a conservative frame of mind. They are determined to preserve their capital come hell or high water, for saner times, so they can re-deploy it under a saner government and a saner monetary system. Their instrument is the ownership of monetary gold. They blithely ignore the siren song promising risk-free profits. Indeed, they could sell their physical gold in the spot market and buy it back at a discount in the futures market for delivery in 30 days. In any other commodity, traders controlling supply would jump at the opportunity. The lure of risk-free profits would be irresistible. Not so in the case of gold. Owners refuse to be coaxed out of their gold holdings, however large the bait may be. Why?

Well, they don’t believe that the physical gold will be there and available for delivery in 30 days’ time. They don’t want to be stuck with paper gold, which is useless for their purposes of capital preservation.

December 2 is a landmark, because before that date the monetary system could have been saved by opening the U.S. Mint to gold. Now, given the fact of gold backwardation, it is too late. The last chance to avoid disaster has been missed. The proverbial last straw has broken the back of the camel.

I have often been told that the U.S. Mint is already open to gold, witness the Eagle and Buffalo gold coins. But these issues were neither unlimited, nor were they coined free of seigniorage. They were sold at a premium over bullion content. They were a red herring, dropped to make people believe that gold coins can always be obtained from the U.S. Mint, and from other government mints of the world. However, as the experience of the past two or three months shows, one mint after another stopped taking orders for gold coins and suspended their gold operations. The reason is that the flow of gold to the mints has become erratic. It may dry up altogether. This shows that the foreboding has been evoked by the looming gold backwardation, way ahead of the event. Now the truth is out: you can no longer coax gold out of hiding with paper profits.

If the governments of the great trading nations had really wanted to save the world from a catastrophic collapse of world trade, then they should have opened their mints to gold. Now gold backwardation has caught up with us and shut down the free flow of gold in the system. This will have catastrophic consequences. Few people realize that the shutting down of the gold trade, which is what is happening, means the shutting down of world trade. This is a financial earthquake measuring ten on the Greenspan scale, with epicenter at the Comex in New York, where the Twin Towers of the World Trade Center once stood. It is no exaggeration to say that this event will trigger a tsunami wiping out the prosperity of the world.

References

By the same author:

The Rise and Fall of the Gold Basis, June 23, 2006Monetary and Non-Monetary Commodities, June 25, 2006The Last Contango in Washington, June 30, 2006Gold, Interest, Basis, March,7, 2007Gold Vanishing into private Hoards, May 31, 2007Opening the Mint to Gold and Silver, February 5, 2008

6 comments:

Many of you have been sending me links to a recent essay from a man whom I greatly respect and consider a friend, Professor Antal Fekete. His piece was dealing with the gold basis. In it he mentioned that backwardation had occurred for a 48 hour period in which spot gold was trading at a premium to the Comex gold futures market, something which we refer to as backwardation.

I want to offer a few comments on his article as a way to answer the many emails I am receiving on this. It will allow me to post one reply instead of vainly attempting to answer so many individual emails that are rapidly threatening to overwhelm me.

First of all, I prefer to use the term backwardation to refer not so much to a negative basis as Antal defines it, but rather to the structure of the particular futures market that is concerned. I do agree with Antal’s use of the terms, “negative and positive basis”. This is really not an attempt to split hairs for me but simply a use of the terms in such a manner that I have learned to use them as a trader.

The normal structure of the majority of futures markets, a few are excepted, is one in which the nearer contracts trade at a discount to the distant month contracts. The reason for the higher price in the distant months is that those prices include the cost of storing the commodity or warehousing it, plus the insurance needed to cover the stored commodity in the event of theft, fire, etc and interest costs. Under normal conditions, the price of those distant commodities converges with the cash price as the time for delivery draws near. That makes sense since if you are no longer storing the stuff, you no longer need to pay for the warehousing nor do you need to insure it, etc.

In backwardation, the front or “nearer” contracts trade at a premium to the distant month contracts. Markets that go into backwardation are markets that are marked by exceptionally strong demand for that particular commodity or exceptionally low supply at current prices. What the market is attempting to do is as Antal states in his piece – that is, to draw out sufficient supply from potential sellers to meet the current levels of demand. If I cannot get you to sell me your scarce apples at $0.25 each, I raise my bid to $0.30. I might be able to make you a bit more willing. If that still did not do the trick, I would have to raise my bid even higher to perhaps $0.35 each in order to entice you to sell that same apple. If you look at the board for “Apple Futures” and see that apples for delivery in June of next year are going for $0.30 but you can sell them now for $0.35, chances are that you will sell those apples to me instead of waiting 6 months, during which anything might happen in the world of apples!

An example of a market that went into backwardation occurred back in the Minneapolis wheat market not all that long ago in which traders bid the price of the front month contract to a never-before-seen price of nearly $25 bushel for wheat! To give you an idea how extreme that was, wheat generally sells for anywhere from $3.50 - $5.50 or so. The market was telling sellers that it wanted hard spring wheat at any price and was willing to pay that price as long as the wheat was delivered RIGHT NOW.

Now as far as backwardation as I define it goes (a structure in the futures market in which the front month gold contract trades at a premium to the distant months), gold is not there yet.

I am linking below a few spread charts that compare the December gold contract to both the April 09 and the June 09 contracts to show you that December is still trading at a discount to both April and June with the notable point that its spread has indeed narrowed. While technically this is not backwardation as I understand the concept, it is a narrowing or a move in that direction and that is something definitely worth paying attention to.

Now let’s go to the term “basis”. That is the difference between the futures market price of a commodity and the spot market or cash price of that same commodity. Antal mentions that gold has exhibited a negative basis, one in which the futures market price is lower than the cash or spot market price. That is, as he points out, very unusual as it would seem to indicate a tightness in the physical market brought about by would-be sellers not willing to part with their gold. Again, Antal is absolutely correct – if spot gold is trading at $750 and the futures market is trading at $745, that is a $5.00 per ounce risk free profit just sitting there waiting for a type of arbitrage. One could immediately sell his physical gold at the $750 price and immediately buy it at $745 in the futures market with the intent of taking delivery to meet his contractual obligations and pocket $5.00 ounce for however many ounces one wished. Buy 5 million ounces of gold at $745 and sell that same amount of gold for $750 and you have gotten yourself a cool $25 million profit less the delivery expenses, etc. Not bad. That is why such a thing does not occur very often nor does it last for long. Too many would jump on the chance for a no-risk trade of such nature. Why then are they not doing so? Antal has answered that question – they are not willing to part with their gold for paper profits! That is what makes this development so noteworthy.

The key is whether or not this sort of thing continues for long so we will definitely have to monitor it.

One thing I wish to add however – trying to construct a gold basis chart is a bit difficult to do. One of the reasons is because the basis, which as Antal correctly defines as the difference between the front month futures contract and the cash or spot price, must be defined at the exact same moment in time due to the wicked volatility of the futures market. The gold futures market generally is moving much faster than the spot price of gold. To get an accurate reading of the gold basis then is very difficult at times due to the lag. Some of you might have noticed this when you have been recently making purchases of gold and are getting a spot price off of a web site such as Kitco and looking at the futures market price. You can see the difference. Sometimes, by the time you get to making that phone call to place your order thinking you have gotten a deal, you are informed that the spot market price of gold has “caught up” to where it was trading on the futures.

In the grain markets we can generally use the price being quoted at one of the elevators and compare that to the futures market price to determine the basis. Same goes for the livestock, etc. In gold however, we have to use the spot market price at any given moment so for a basis chart to be accurate, in my opinion, it must give the spot market price of gold and the futures market price of gold at the exact same hour of the day. For example, one could take the London PM fix done at 9:00 CST, and take the hourly price of gold on the Comex front month contract and compare the two prices. That would give you an accurate basis chart.

If anyone out there actually has some basis charts for gold, I would be interested in knowing how they were constructed. What time did they use to make the comparison?

I can give you a brief basis chart using the last week and the December futures contract at 9:00 AM CST and comparing that to the London PM Fix so that you can see the basis. It is indeed negative in some instances as Antal has mentioned.

In closing let me just state how grateful I am for Antal’s excellent essay and for his innumerable talents which he brings to bear for the benefit of those who love honest money! I was not fortunate enough to have been able to sit in on his classroom series but I have no doubt whatsoever that those that did came away with a wealth of knowledge.

That was a very interesting treatise, all the more so since the title contained the words “Red Alert” and three exclamation points! The Mogambo Guru would be thoroughly awed by the use of three exclamation points. Nevertheless, the ominous title is an appropriate introduction for Mr. Fekete’s earthshaking conclusion.

I was particularly intrigued by this simple explanation of the “basis,” which if negative, indicates backwardation (Mr. Fekete’s emphasis):

“The gold basis is the difference between the futures and the cash price of gold. More precisely it is the price of the nearby active futures contract in the gold futures market minus the cash price of physical gold in the spot market.”

So the basis, simply put, is the future price minus the present price. But which present price? The manipulated CRIMEX spot price? Even by that standard gold went into backwardation briefly, as Mr. Fekete points out. But what about alternative prices? If one applies the same calculation using, not CRIMEX prices, but “street” and “ebay” prices, then we’ve been in consistent backwardation for quite a while now, because those alternative prices have been 10-100% higher than the futures prices, not the mere 2-3% indicated by CRIMEX prices! Moreover, those alternative prices represent a more immediate exchange of cash for physical metal than the CRIMEX, which in my opinion, makes them an even truer gauge by which to ascertain the “cash” price. The prices people pay on ebay, in coin shops and to online metals retailers are “real” cash prices in the here and now.

I realize I’m slightly mixing apples and oranges here by comparing “street” spot prices to CRIMEX futures prices. However, there is no futures market for “street-level” exchanges of physical metal and cash, and the “street” prices are perfectly legitimate and will become even more so if things get so bad that we have to trade silver coins for goods because nobody will take dollars anymore.

The essay nicely explains why backwardation in gold is so significant, more so than for commodities. Since the gold and inventories are so huge compared to new production, backwardation indicates a major shift in human sentiment that cannot be overcome by new production (especially with miners shutting down because the “official” exchange prices are too low).

The essay also confirms what has seemed obvious to so many of us, but which has been vehemently denied: that mints around the world have been reducing availability of precious metal coins to the public because they are having difficulty getting their hands on precious metal! Duh!

The essay also reinforces my belief that mints around the world have sold precious metal coins to create the illusion of public accessibility and imply some sort of government fealty to a “gold standard” in order to bolster their fiat currencies. In the case of the U.S. I believe the U.S. Mint sells precious metal, legal tender coins in part to adhere to the Constitutional requirement that money be comprised of gold and silver. By selling such coins, the U.S. Government can claim to be adhering to the Constitution.

Thanks for the comment. I just want to point out that the sensationalism in the headline is Fekete's, not mine. Though it may very well be warranted. As Clink said on USAGOLD:

I have been following the draw-down of Comex stocks (along with many others here, I’m sure), and have been disappointed by the robust start to the December deliveries which seem to have stalled. However, the good professor seems to be telling us that something fundamentally more important has taken place this week."

I recently completed the same mathematics that helped me so much in 1980 to determine the price that would be required to balance the international balance sheet of the US.

Balancing the international balance sheet is gold's mission in times of crisis.

I recently did the math again and was sadly shocked to see what the price of gold would have to be to balance the international balance sheet of the USA today. That price for gold is more than twice Alf's projected maximum gold price.

My compliments go to Alf for his work that has been spot on for a good deal of time.

All our tools are a crystal ball of sorts; a kind not having 100% input from the adopted discipline. Certainly Alf's involves more than simple technical analysis talent. It is quite rare for two Gann guys ever to see the same thing in an axiom of TA. What Alf speaks about lately makes me feel God is long gold even if Oliver is short. You might recall it was Alf who correctly called the Uranium market.

None of us get it right all the time. For the speculator, you are only as good as your last call.

Let's put on our practical thinking hats. I am inviting opinions from both our academic reader as well as those that believe answers are more accurate when derived by the "follow the money" concept.

The Fed says and statistics support that the majority of the $8.5 trillion in funds injected into the economy in many ways was to protect the US financial community. This has given comfort to the establishment intellectuals that there is no inflationary implication as a result of this massage and unprecedented liquidity injections.

Follow the money approach

The US Federal Reserve made $8.5 trillion available to Wall Street and other entities with OTC derivatives in their inventory. These "assets" have the potential for causing bankruptcy.

It is claimed that the majority of these funds will not have an inflationary impact because of the huge amount of T bills, bonds and note sales that will offset the inherent liquidity injections.

The main buyer of the Treasury instrument issued was China.

China sold US Agencies and as a courtesy bought US treasuries, claiming no negative impact on US financial plans.

The inviting question is who got sterilized? Sterilization impacts the entity that buys the T-bills.

The conclusion then is that it is China, not the USA that received the sterilization process tool. The Chinese, being no fools, offset this process by selling US Agency instruments.

It follows that the USA got the liquidity but not the sterilization, leaving all those funds locked and loaded to fulfill Dr. Milton Friedman's accurate statement that inflation is monetary, not demand-pull or cost- push motivated.

The Fed figures say sterilized, but it is totally false when the "follow the money process" is utilized to understand the action.

China however did remain relatively dollar neutral as the product of selling agencies to buy T-bills.

Therefore the final answer is that $8.5 trillion that is unspecialized has been injected into the US monetary system.

Where is the Beef?

When the Fed buys OTC derivatives say from AIG, Fanny and Freddie and guarantees them against loss or keeps them on their balance sheet, the Fed becomes the principal counterparty as the loser to each OTC held or guaranteed.

It is reasonable then to assume that a non-performing OTC derivative instrument becomes a performing asset as long as it is held or guaranteed by the US Federal Reserve. The Fed would need to be responsible for the obligations of the losing counterparty to the special performance obligation.

If these defunct instruments are now functional it is reasonable to assume that bailout entities were losers in the specific performance contracts known as OTC derivatives. There has to be one or a daisy chain of winners out there of $8.5 trillion, either paid out or held as a full value position

Who are they?

Now let's look at the assumption that the $8.5 trillion is not a factor because the intellectuals state that all it does is fill a black hole of losses.

You own a junior gold that has been under attack by naked and pool short sellers. Mr. Oliver has done the work of god to make cold calls to major stockholders (discovered in required filings) informing them of his opinion that the entity is overpriced at zero.

I now come to your house informing you that I feel sorry for you and hold the naked and pool short seller in contempt, therefore here is a check for the difference between your cost and the present market value.

Does that fill a black hole of losses or put you back in business? It puts you back in business with your wealth factor reestablished.

What intervention factor will start the flow of the absolutely unsterilized $8.5 trillion dollars of liquidly into the business section?

The answer is significant FISCAL STIMULATION through Quantitative Easing (aka wild-ass money printing) will trigger the dollar's death by inflation of the currency unit. When road, schools, special education, music, athletic, teacher's salaries, the no child left back, road building and local infrastructure building providers are granted Federal contracts with Federal guarantees of borrowing, they go to the bank. What bank against a Federal fiscal stimulus contract or guarantee will fail to lend up to 90% of the required funds?

That will open the barn door of liquidity.

This is followed by inflation then hyperinflation (a currency event not an economic event) in the midst of a recession so deep it threatens to be the second Great Depression.

The dollar declines below .72 and gold moves above $1024 on its way to $1650. What would make Alf Field's technical projection of the price of gold at $3000, $5000 or even $10,000 correct?

The answer to that question is also easy: $8.5 trillion in government bailouts and direct cash injections as fiscal stimulus while quantitative easing throws money in the street for people to pick up (Bernanke and the famous Electronic Helicopter Money Drop Defalcation fighting speech will do the trick).

Obama will be cheered as saving the US economy for at least one year while the equity markets gets its 1930 rally for a year.

Keep in mind that the grease of the wheels of the equity market has been and always will be LIQUIDITY for a short to medium term rally.

Weekend Events

Republic Windows and Door Corporation got a surprise on Friday when it furloughed all its workers as a result of Bank of America calling their cash flow, plant and equipment based loan.This morning and all weekend the employees are marching around the facility demanding their severance pay and reimbursement for vacation days earned after only a 3-day notice.

The Federal Warrant Act demands employees get 60 day notices or get paid for 60 days pay when furloughed.

The workers are after Bank of America and the assets of the firm to meet their legal demand.

As a side note the company does not have the funds for severance payment or its contribution to employee's health insurance.

Most employees' health insurance was up for renewal now.

The Bank of America was asked to extend the company loans for severance and health insurance. Their reply was "you have to be kidding."

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Disclaimer

The above is presented for educational and/or entertainment purposes only. Under no circumstances should it be mistaken for professional investment advice, nor is it at all intended to be taken as such. The commentary and other contents simply reflect the opinion of the author alone on the current and future status of the markets and various economies. It is subject to error and change without notice. The presence of a link to a website does not indicate approval or endorsement of that web site or any services, products, or opinions that may be offered by them.